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Chapter 8: The New-Keynesian Theory of Aggregate Supply
Instructor’s Manual
Chapter 8: The New-Keynesian Theory
of Aggregate Supply
Problem 1
The classical supply curve assumes that the labor market is perfectly competitive, wages are
perfectly flexible, and the labor market clears. The implication of these assumptions is that
money neutrality holds and that the classical aggregate supply curve is vertical. In the newKeynesian model, labor markets are not perfectly competitive and wages are not flexible but
sticky. As a result, money neutrality does not hold in the short run and nominal variables like the
price level can have effects on real variables like aggregate output by creating changes in the real
wage. As a result, the new-Keynesian aggregate supply curve is not vertical but slopes upward.
Problem 2
The primary cause of nominal rigidity described in the text is wage contracts, either explicit
contracts or implicit contracts made between firms and workers. Minimum wage laws also limit
the variability of nominal wages downward. Uncertainty about current inflation can also lead to
changes in nominal wages that lag behind changes in the price level. Wage contracts and
minimum wage laws seem to be more important in explaining why nominal wages are slow to
decrease as opposed to why they might be slow to increase.
Problem 3
Past inflationary experience might be an important factor in determining how fast nominal wages
adjust within a country. For instance, in Brazil, which has had a history of high and variable
inflation, almost all wage and price contracts have been indexed, meaning they automatically
adjust to any changes in inflation. As a result, you would expect wages within such a country to
adjust much more quickly than in a country like the U.S. where wage indexing is not universal.
The implication of these sorts of cross-country differences is that you would expect the aggregate
supply curve in Brazil to be much steeper and closer to the classical model’s vertical aggregate
supply curve than the aggregate supply curve in the U.S.
Problem 4
The proposition of the neutrality of money states that changes in nominal variables like the
money supply have only proportional effects on other nominal variables and have no effect on
real variables. For example, a 50% increase in the money supply should increase nominal wages
and the price level by 50% as well, but leave the real wage, the real interest rate, unemployment,
and output unchanged. Money is not neutral in the short run within the new-Keynesian model
because nominal wages cannot fully adjust to changes in the money supply. For example, if the
money supply increases 50% in the new-Keynesian model, nominal wages cannot increase by
50% because of nominal rigidity. As a result, the real wage will change which will affect
unemployment, real interest rates, output, and other real variables.
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Chapter 8: The New-Keynesian Theory of Aggregate Supply
Instructor’s Manual
Problem 5
If all nominal wages are linked to a price index, monetary shocks cannot have real effects (i.e.,
they cannot have any effect on output and employment) in a Keynesian nor in a classical
economy.
This, of course, is not surprising in the classical model. But recall that the Keynesian model
predicts that changes in nominal variables, say, the price level, will affect real variables since the
nominal wage is rigid in the short run. Therefore, in the short run the actual real wage may differ
from the equilibrium one1. However, with indexation of wages, any change in the price level will
be followed by a similar change in the nominal wage (since the nominal wage is adjusted
according to the "cost of living"), so that the real wage will have to be the equilibrium one. In
other words, the real wage rate is effectively fixed even in a Keynesian economy (with cost-ofliving adjustment). Hence the aggregate supply curve will be vertical.
Problem 6
Okun’s law says that an increase in the unemployment rate by 1% is accompanied by a 3%
decline in GDP below trend. Therefore, if the unemployment rate increases from 3% to 4%, GDP
will fall by 3% below trend.
Problem 7
A 10% increase in the money supply will increase the price level. However, because of sticky
wages, the nominal wage will rise by less than the increase in the price level in the short run. As
a result, the real wage falls which reduces unemployment below the natural rate. The short run
new-Keynesian aggregate supply curve is upward sloping so the increase in aggregate demand
caused by the increase in the money supply will not only increase the price level but also increase
aggregate output. In the long run, nominal wages will have a chance to adjust and increase by the
full 10% so that the real wage returns to a level consistent with the natural rate of unemployment.
Problem 8
In the classical model, wages and prices are perfectly flexible so that a 10% increase in the money
supply immediately increases prices and nominal wages by 10%. The real wage and
unemployment remain unchanged. Aggregate demand increases, but aggregate output remains
unchanged because the aggregate supply curve is vertical. Thus, all nominal variables increase
by 10% while all real variables remain unchanged, which is consistent with money neutrality.
The classical model differs from the new-Keynesian model because money neutrality holds in
both the short run and the long run.
1
The equilibrium wage rate is the wage rate that clears the labor market if there are no search costs. If there
are search costs, then it is the wage rate at which unemployment equals the natural rate.
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Chapter 8: The New-Keynesian Theory of Aggregate Supply
Instructor’s Manual
Problem 9
Say’s Law says that “supply creates its own demand.” The classical model is consistent with
Say’s Law because aggregate output is determined only by the position of the aggregate supply
curve. However, in the new-Keynesian model the short run aggregate supply curve is upward
sloping because of nominal rigidity. As a result, changes in aggregate demand as well as changes
in aggregate supply can affect the levels of aggregate output. Thus, Say’s Law does not
necessarily hold in the new-Keynesian model.
Problem 10
Real wages are countercyclical in the new-Keynesian model. For example, assume there is a
decrease in the money supply. Prices will fall faster than nominal wages so that real wages rise.
At the same time, unemployment will rise and aggregate output will fall. Thus, real wages rise
when output falls in the new-Keynesian model. Looking at Box 8.2 in the text you will see that
this explanation is consistent with what happened during the Great Depression. Both nominal
wages and prices fell during the Great Depression, but prices fell by more so that the real wage
was rising at the same time that unemployment was rising and output was falling. The only way
that the classical model could explain the countercyclical movement of real wages is through a
decrease in labor supply that would increase real wages and decrease output simultaneously.
However, trying to explain the Great Depression as the result of a large decrease in labor supply
is not plausible.
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